For the past three years we have extensively used preferred stocks in portfolios because we have felt that interest rates were likely to remain low. The preferreds we favor have paid dividends ranging between 7.8% and 10%, which are very nice returns in a relatively stable investment. We utilized preferreds for this dividend yield, not seeking any capital appreciation although in many cases we got both. In this column I will discuss how preferreds work, what to seek in evaluating them, and why I think the time is still good for investing in preferreds despite rising interest rates.

There are two kinds of stock: the best known variety is common stock, which is what is usually referred to when people talk of owning stock in a company. Corporations can also issue preferred stock, which is a class of stock that is given preferences, such as for dividends or liquidation of the company should the company dissolve and its assets be distributed among its shareholders. Preferred stock is a type of debt – the company is borrowing money from those who own it. The shares have a “coupon”, which is the rate of interest the preferred stock pays. The preferred stock often has a call date – a date after which the company can pay off the preferred stock at a predetermined par value (usually the original cost per share). The call date protects the company in case interest rates decline and the company is in a position to borrow money at an interest rate that is lower than the coupon of its preferred stock. Many preferreds have no maturity date, as bonds do, so that the preferred shares can be perpetual.

As an example: company X wants to raise $100 million for expansion. One way they can do this would be to issue preferred shares with a 7% coupon (the coupon is determined by the company’s financial strength and the general level of interest rates), callable at par in five years (par is generally $25). Those preferred shares are sold in the public market and the $100 million goes into the company’s treasury. Every year thereafter, the company will pay $7 million in interest to the preferred shareholders (paid quarterly). The price of the shares, which usually start to trade at $25, can go up or down, depending on the movement of interest rates and if the company has any particularly good or bad news. Most preferred stocks have been trading at slight premiums the last few years as declining interest rates moved prices up, much like other fixed income assets.

At the end of five years, if interest rates have declined and the company believes it can issue new preferred shares with a lower coupon than 7%, they may issue the new preferred shares – say at 6%. The money raised from this new offering would then be used to pay off the older shares, which is known as “calling” those shares. If an investor paid more than $25 for the shares, there will be a slight capital loss as that investor will receive $25 for the shares. Because of this, investors must be careful to take into account the call date and the price paid for the preferred shares. Investors who gauge these factors accurately have done very well over the last three years, outperforming equities by a wide margin. Even if the shares are bought at a slight premium and are called, in many cases the high yielding dividend more than compensates for the slight loss of principal.

In evaluating preferred stock, we look for the following:

Preferred Stock of REIT’s

A sector where we have done quite well buying preferred stock is REIT’s. We like their preferreds because many REIT’s have substantial cash flows and predictable income, and pay a common share dividend that provides a layer of protection for the preferreds – since the common dividend would have to be suspended before the preferred dividend would be suspended.

The REIT’s whose preferreds we have been buying the last three years pay dividends of 7.8% to 10%, which we have found very attractive in the interest rate environment during these years. These securities have risks – they can decline in price if the company has bad earnings, the dividend is perceived to be in question or some catastrophe befalls the company. Naturally we evaluate these companies to judge the likelihood of any such events.

Interest Rate Movements

Preferreds will decline in price if interest rates spike up. But the decline is far less than for bonds. Preferreds tend to trade in a narrow range, which is something else we like about them. When interest rates rose recently, the prices of the preferreds in our portfolios declined only slightly.

While interest rates have risen in the last couple of months and may go a little higher, we expect interest rates to remain relatively low until at least after the election (Presidential, not Recall!). We think that the incumbent will exert enormous pressure on the Fed to keep rates low to spur an economic recovery through the election. That gives us a good amount of time to continue to capture returns that we think will be higher than equities returns over this same period, while avoiding the risks associated with equities investments.

Summary

Few investors understand how preferred stocks work. During the last three years, while equities were declining sharply and equities markets were extremely volatile, we were able to produce returns of 8% - 10% for clients by investing in preferred stocks. These fixed income assets pay attractive yields and generally do not fluctuate a great deal in price. Investors mistakenly flocked to bonds when interest rates were at 45 year lows – they should have been investing in preferreds.